Speculators are essentially rolling the dice with their money. Photo: Alan Cleaver, Flickr
When it comes to investing your hard-earned dollars for retirement, your choices will make a huge difference in whether you are eating caviar or cat food in your last decades. Here's one critical decision you need to get right: invest, don't speculate.
Many people might think they're investing when they're actually speculating -- a risky activity with a lower opportunity for profit and success. In case you're not clear on the difference, along with where you fall on the investing-speculating continuum, here are a few questions to ask yourself:
Are you buying penny stocks?
This is an easy one. If you're buying stocks valued at less than $5 per share, you're speculating. These stocks are very risky. If a penny stock is tied to a big, well-known company, then that company has likely fallen on hard times to bring its stock price so low. A penny stock is more likely to be tied to a small, obscure, and unproven company. One that is easily manipulated by pump-and-dumpers, who get naïve folks excited about a possible cure for cancer, or the imminent discovery of gold, or even a "guaranteed" surge in its stock price. No stock price's future moves are guaranteed. Even great companies stumble on occasion.
Investing in penny stocks is very risky. Photo: Memphis CVB, Flickr.
Do you know why you've invested in each of your holdings?
It's a useful exercise for all investors to jot down, perhaps in a paragraph, exactly why they bought each of their holdings. After all, if you can't remember why you bought a stock, then you might never know when to sell.
For example, imagine you bought shares of Facebook. You might jot down that you bought because of its huge reach and great potential. You might have been optimistic about its venture into video advertising and its entry into professional networking, where it will compete with LinkedIn. It is already a giant in online advertising, and through its social media site has gobs of information on its users and their interests, enabling more targeted advertising. As of the end of 2014, the company had 890 million daily active users worldwide, and 745 million mobile users.
Once you have information like that, when you periodically check on the company you can be on the lookout for unpromising changes, such as if Facebook's video advertising never takes off or its professional site bombs. You can also add more to your original list as the company offers more reasons to be hopeful. In this way you're not just wildly guessing about how you'll profit from your investment, but making an educated guess, based on data and catalysts.
Do you know how each of your holdings makes its money?
This question refers to company business models. If you don't have a good handle on how a company makes its money, you'll have trouble understanding when it's in trouble or just how promising it is. It's not enough, for example, to say that Amazon.com sells things. Instead, you need to appreciate that it does so on a massive scale, without any storefronts, and that it saves a lot of money by not having salespeople and brick-and-mortar stores to maintain. Companies such as LinkedIn and even The Motley Fool have business models in which they offer significant value to customers for free but also offer premium products and services that generate revenue.
If you don't know what you're doing, you can lose a lot of money. Photo: bark, Flickr.
Do you know what your holdings' competitive advantages are?
Amazon.com's business model helps it operate less expensively than many retail rivals. Its scale and network effect are advantages, too. Many shoppers will use Amazon because they know it carries almost everything they might want. This helps it succeed and offer more goods. Similarly, eBay is successful in part because sellers go there for its many buyers and buyers go there because of the sellers' breadth of wares. It also has a very low-cost business model. While Amazon.com must maintain many warehouses and ship out orders, eBay just takes a cut of the transactions it facilitates, needing very little real estate and relatively few employees.
Are you engaging in value investing or seeking highfliers?
You would also do well to ask yourself whether you're engaging in value investing or are chasing highfliers. Value investors, a group that includes Warren Buffett and many other investing titans, seek companies that are trading for significantly less than their intrinsic value. They can therefore buy them with a built-in margin of safety as they wait for the stock price to rise, approaching fair value. All investors love growing companies, and the faster the growth, the more promise -- but you shouldn't be willing to pay any price for an exciting, fast-growing company. If its stock price has gotten ahead of itself and become overvalued, it stands a good chance of falling, and causing you to lose money (or to have to wait a long time to recover your money). The best of both worlds is to find healthy, growing companies with undervalued stocks.
Are you engaging in fundamental or technical analysis?
If you find yourself reading about and thinking about and perhaps even (gasp) acting on a stock's price movements, seeing certain shapes in charts of these movements (a cup and handle! Head and shoulders! warthog and toothbrush!), you're engaged in technical analysis. To many people, that's just a form of speculation, as technical investors often don't even pay attention to what a company does or how well it is growing and innovating. Instead, they focus predominantly on stock prices and perhaps trading volume.
A sounder approach is fundamental stock analysis, in which you study the company and its financial statements, evaluating its growth rates, debt levels, profit margins, free cash flow, and so on. You also assess the trends for these kinds of numbers, wanting to see profit margins rising, revenue growing at a good clip, inventories growing no faster than revenue, etc. Investors, as opposed to speculators, should see themselves (rightfully) as part owners of the companies in which they own stock. Ideally, they'll get to know the company well and follow it, aiming to own it for many years.
Speculating is risky, while investing sensibly is the way to go. Be sure you're a grounded investor, with realistic expectations and patience. Many speculators lose a lot of money and often write off investing, when it could reward them well if they approached it in a rational manner.
